Tax Court Includes Certain Trust Assets in Decedent’s Estate

In Estate of Olsen, T.C. Memo 2014-58, the Tax Court held that a decedent’s estate was required to include in the value of the gross estate some of the assets held in a trust she created.

Grace Olsen died on Dec. 9, 1998, survived by her husband, Elwood Olsen, and her three children. Grace had created a revocable trust during her life (the GTO trust) that governed the disposition of her assets on her death. On Grace’s death, Elwood, the successor trustee of the GTO trust, was directed to transfer the trust assets into three separate trusts: (1) marital trust A,, (2) marital trust B, and (3) the family trust.” Elwood was appointed as trustee of all three trusts. He was directed to fund the two marital trusts with the maximum estate tax marital deduction less the sum of: (1) the value for federal estate tax purposes of all property includible in Grace’s gross estate and qualifying for the marital deduction that passed to Elwood as a result of Grace’s death under the other provisions of the GTO trust or outside of the GTO trust, and (2) the amount necessary to increase Grace’s taxable estate sufficiently to use all available credits for federal estate tax purposes. After setting aside this amount for the two marital trusts, Elwood was directed to fund marital trust A with assets having a value of $1 million reduced by the amount of generation-skipping transfer (GST) tax exemption allocated to transfers made by Grace during her lifetime. Elwood was directed to fund marital trust B with the remaining amount set aside for the marital trusts, and he was directed to fund the family trust with the remaining property in the GTO trust.

Both marital trusts provided that Elwood would receive all trust income and so much of the principal as the trustee determined to be advisable for health, education, maintenance and support (HEMS). The family trust provided for discretionary distributions of income and principal for Elwood’s HEMS. The family trust also gave Elwood the power, exercisable during his life or at his death, to appoint trust property to Grace’s children and grandchildren and/or to any charitable organization(s). On Elwood’s death, the trustee was directed to distribute the remaining principal in marital trust A to a “Generation Skipping Trust” created under the GTO trust instrument. The remaining principal in marital trust B and in the family trust (if Elwood didn’t exercise his power of appointment (POA) over the family trust property) would be divided into separate shares per stirpes for Grace’s then living descendants and either distributed outright or held in further trust.

After Grace’s death, Elwood filed a federal estate tax return reporting the total value of the assets in the GTO trust to be $2,104,695 and that those assets were to be distributed as follows: $1 million to marital trust A, $504,695 to marital trust B and $600,000 to the family trust. Elwood made an election under Internal Revenue Code Section 2056(b)(7) with respect to the assets passing to marital trust A and marital trust B and claimed a marital deduction of $1,504,695. Although Elwood reported that the assets in the GTO trust would be divided into three separate trusts in this manner, Elwood failed to segregate the GTO trust into the three separate trusts and failed to fund those trusts as the GTO trust instrument required. During his lifetime, Elwood made three significant withdrawals from the GTO trust totaling $1,474,780: (1) a withdrawal of $249,550 in May 2002 that was used to make a charitable contribution to Morningside College, (2) a withdrawal of $831,252 in June 2004 that was used to make another charitable contribution to Morningside College, and (3) a withdrawal of $393,978 in February 2006 that was deposited into one of Elwood’s personal accounts. Elwood failed to provide any accountings for these withdrawals to the beneficiaries of the GTO trust.

Elwood died on Feb. 25, 2008. At that time, the value of the assets in the GTO trust was $1,071,224. Elwood’s son, Ty Olsen, was appointed as the personal representative of Elwood’s estate and the successor trustee of the GTO trust. Ty decided that he would create marital trust A, marital trust B and the family trust at that time and was faced with the decision of how to fund these trusts. He was unable to find any records in which Elwood indicated whether: (1) he’d made the withdrawals from the GTO trust pursuant to any particular provision or authority granted in the GTO trust instrument, and (2) the source(s) of those withdrawals was/were marital Trust A, marital Trust B and/or the family trust.

Ty decided to treat Elwood’s withdrawals in 2002, 2004 and 2006 as coming entirely from marital trust A and marital trust B, with the result that the marital trusts were entirely depleted by the time of Elwood’s death. Based on this decision, Ty treated the marital trusts as not holding any assets of the GTO trust and the family trust as holding all of the assets of the GTO trust as of Elwood’s death. Accordingly, when Ty filed a federal estate tax return for Elwood’s estate, he didn’t include any portion of the GTO trust assets in the value of Elwood’s gross estate.

Notice of Deficiency

The Internal Revenue Service issued a notice of deficiency with respect to Elwood’s estate, determining that the entire value of the GTO trust as of the applicable alternate valuation date (that is, $1,001,905.51) should have been included in Elwood’s gross estate under IRC Section 2044. The IRS’ position was that the family trust shouldn’t be considered to have held any of the GTO trust assets on the date of Elwood’s death and that the marital trusts should be considered to have held all of the assets of the GTO trust on that date; consequently the value of all of the assets held in the GTO trust at Elwood’s death should have been included in the value of his gross estate.

Ty’s rationale in treating Elwood’s withdrawals as coming entirely from the marital trusts was that Grace’s intent, as expressed in the GTO trust instrument, was to minimize estate taxes at the death of the survivor of her and Elwood and that Elwood’s duty as trustee of the GTO trust was to minimize estate taxes for the benefit of the remainder beneficiaries. Because Elwood’s estate would owe no estate taxes if the withdrawals were treated as coming from the marital trusts, Ty believed this treatment was most consistent with his parents’ intent. The IRS argued that Grace’s intent was irrelevant in determining from which trusts the withdrawals were made. Pursuant to the GTO trust instrument, Elwood had an inter vivos power to appoint the assets in the family trust to charity and for his personal benefit. He didn’t have a similar POA over the assets in the marital trusts; in fact, IRC Section 2056(b)(7) expressly prohibits trusts qualifying as qualified terminable interest property from containing such a POA. Therefore, the IRS’ position was that all three withdrawals must be treated as having come from the family trust.

Tax Court Ruling

The Tax Court held that $1,080,802 of the withdrawals from the GTO trust (that is, the May 2002 withdrawal of $249,550 and the June 2004 withdrawal of $831,252) should be considered to have been made from the family trust and that the withdrawal of $393,978 in February 2006 should be considered to have been made from the marital trusts. The court reasoned that the terms of the family trust expressly authorized Elwood to appoint principal from that trust to charitable organizations whereas the marital trusts didn’t so authorize. Therefore, the amounts that were withdrawn to make contributions to Morningside College must have come from the family trust. The marital trusts, however, did permit principal distributions to Elwood for his HEMS. Although the family trust also permitted principal distributions for Elwood’s HEMS, the money that Elwood withdrew for his personal use was more properly viewed as a distribution from the marital trusts because Grace didn’t intend for Elwood to receive distributions of income or principal from the family trust until the assets in the marital trusts were exhausted. Thus, Elwood’s estate was required under Section 2044 to include in the value of the gross estate $607,921.51. This represented $1,001,905.51, the value of the GTO trust on the applicable alternate valuation date, reduced by $393,978, the February 2006 withdrawal from the GTO trust.